Thursday, November 21, 2013

Strategies for Achieving Scale in the Residential Remodeling Industry

Since its inception nearly twenty years ago, the Remodeling Futures Program of the Joint Center for Housing Studies has been investigating trends in contractor size, concentration, performance, and survivorship to better understand the evolving structure of contractors serving the residential remodeling market. Unlike the national homebuilding industry, which saw significant achievements of scale and consolidation in recent decades, the professional remodeling industry continues to be highly fragmented, where the vast majority of remodeling companies are relatively small, single-location businesses that likely will not experience any significant growth over the course of the business’s life-cycle. Two thirds of remodelers are self-employed, and fully half of payroll establishments have total revenues of under $250,000. Yet our research suggests that there are significant benefits to be gained through larger scale businesses.

The evidence for the benefits of scale in the remodeling industry is compelling. Comparing the revenue growth of larger-scale remodeling companies to the industry as a whole shows that larger-scale remodelers benefit from significantly stronger revenue growth. Where the average revenue of all residential remodeling contractors increased less than 18% in inflation-adjusted terms during the last industry upturn from 2002-2007, larger-scale firms with annual revenues of approximately $1 million or more increased their average revenue by over 30% during the same period. Additionally, larger-scale remodeling contractors benefit from higher revenues per employee, which implies that they enjoy greater labor productivity (Figure 1). While an admittedly crude measure of efficiency and productivity, the trend is obvious that larger remodeling businesses are seeing a benefit of scale.

Source: Unpublished tabulations of the 2007 Economic Census of Construction, U.S. Census Bureau.

Furthermore, there is evidence that larger-scale remodeling firms suffer significantly lower failure rates across the rocky business cycle (Figure 2). Remodelers with estimated receipts of $1 million or more during the last industry upturn in 2003–04 had a failure rate of only 2.7% that year, and their failure rate remained essentially unchanged during the cyclical downturn in 2009-10. These low and stable failure rates for the largest remodelers are in stark contrast to the roughly 20% failure rates of smaller remodeling businesses. With the efficiency gains that come along with achieving scale economies, larger remodeling companies seem much better equipped to ride out the volatile business cycles in the remodeling industry.

Source: JCHS estimates using U.S. Census Bureau tabulations of the 1989-2010 Business Information Tracking Series.

Although larger-scale remodeling firms enjoy significant benefits to scale, the industry has remained fragmented over time due to the many obstacles to gaining scale such as low barriers of entry, highly customized work, and difficulty attracting capital, to name a few. Understanding how remodeling companies are overcoming these major hurdles in their pursuit of scale economies should provide insights into how the industry is likely to continue evolving over the next several decades, as well as what opportunities exist for more widespread consolidation moving forward.

To this end, the Remodeling Futures Program has been conducting in-depth interviews with several dozen remodeling industry leaders including founders, presidents, and CEOs of larger-scale remodeling companies on the topic of benefits from scale and challenges and strategies for achieving scale. Key research questions for the project focus on exploring the major approaches used for gaining scale, challenges and opportunities unique to each type of strategy, and whether certain types of remodeling specialties or niches are more or less likely to attempt to establish a larger-scale or even national presence.

A key insight gained from these interviews is that successfully achieving scale in the remodeling industry has more typically occurred using strategies outside of the traditional model of organic expansion and acquisition. Common among remodeling companies that have been successful in establishing a larger-scale presence are strategies or approaches that involve strategic partnerships or arrangements, such as:

Strategic Alliances: When expanding to new markets, building brand awareness and trust takes a significant investment of time and money, so securing strategic alliances or partnerships with long-standing, nationally known manufacturing and retail brands to sell, furnish, and install products and projects is very effective for gaining entry into new markets with instant name recognition and credibility with consumers, who, given the same quality and price, will choose the brand with which they are already most familiar. Strategic alliances ultimately provide a contractor with a high volume of quality leads in new markets.

Franchising: Franchising is a well-established scaling strategy in many industries that allows a business to quickly expand its brand recognition and reach without the challenges of managing each independently-owned and operated franchise location. Franchising in the remodeling industry seems to be more successful with single focus or specialty businesses, such as painting and insurance restoration services that are easier to standardize and streamline.

Outside Investment: Pursuing outside investment through private equity partnerships, for example, provides a company with an influx of working financial capital for expanding into new markets, developing additional lines of business or products, or restructuring operations or management to better foster growth. Though a highly effective way to scale a remodeling company toward a national presence, this strategy of securing outside investment has not been more common because investors are deterred by the relatively high-risk nature of such a volatile and fragmented industry.

Since the remodeling industry is so diverse, with business segments and market niches that cover the full spectrum from full-service and design/build firms to specialty replacements and handyman services, there is no one-size-fits-all approach to achieving scale. Companies often employ multiple business strategies and arrangements either consecutively or concurrently. Some of the biggest benefits of scale reported by industry leaders include improved buying power, lower costs, efficiency of centralized accounting and management, and improved use of technology systems, as well as geographic diversity (i.e., not being dependent on the economic strength of one market or region), greater ability to explore new business opportunities, greater consumer recognition and trust, and being able to provide growth opportunities to key team members. The many issues surrounding this topic of strategies, benefits and challenges of achieving scale in the residential remodeling industry will be explored in greater detail in an upcoming Joint Center working paper.

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